NASAA Series 65 — All Questions

Treasury STRIPS are best described as:

• a.Treasury securities that pay semiannual interest and whose principal adjusts with the CPI each period
• b.Short-term Treasury discount securities that mature in four to 52 weeks
• c.Agency securities that separate a mortgage pool's interest and principal payments into separate classes
• d.Zero-coupon securities created by separating a Treasury bond's interest and principal payments✓

STRIPS separate a Treasury's coupon and principal into individually tradable zero-coupon pieces sold at a discount and maturing at face value. They generate taxable phantom income annually even though no cash interest is received. CPI-adjusted principal describes TIPS, four-to-52-week discount paper describes T-bills, and splitting a mortgage pool into interest-only and principal-only classes describes mortgage strips, not Treasury STRIPS.

Which statement about federal agency securities is accurate?

• a.GNMA securities are backed only by the credit of the mortgage pool, while Fannie Mae and Freddie Mac securities are fully backed by the Treasury
• b.Securities of GSEs such as Fannie Mae and Freddie Mac are not directly backed by the full faith and credit of the Treasury, unlike GNMA✓
• c.Interest on agency securities is always exempt from federal income tax
• d.All agency securities, including those of Fannie Mae and Freddie Mac, carry the full faith and credit of the U.S. government

GNMA (Ginnie Mae) carries the full faith and credit of the U.S. government, but government-sponsored enterprises like Fannie Mae and Freddie Mac carry only implied backing, so they yield slightly more for the added credit risk. The backing is therefore not reversed between them, and not all agency issues carry the government's full faith and credit. Agency interest is generally taxable at the federal level.

A debenture is a corporate bond that is:

• a.Secured by a first mortgage on the issuer's land and buildings
• b.Backed only by the general credit and good faith of the issuer, with no specific collateral✓
• c.Backed by securities of other companies that the issuer deposits with a trustee for the bondholders
• d.Secured by equipment such as railcars or aircraft, with the trustee holding title until the debt is repaid

A debenture is unsecured debt backed solely by the issuer's creditworthiness. A mortgage bond pledges real property, a collateral trust bond pledges securities held by a trustee, and an equipment trust certificate pledges equipment. Each of those is secured, which a debenture is not. Debentures are also not government guaranteed.

A collateralized mortgage obligation (CMO) is best described as a security that:

• a.Passes interest and principal from a mortgage pool straight through to investors pro rata
• b.Is a bond issued by a state housing agency and backed by the state's full taxing power
• c.Is a debt security backed by pools of auto loans or credit card receivables
• d.Divides the cash flows from a pool of mortgages into tranches with different maturities and risk profiles✓

A CMO repackages the cash flows from a pool of mortgages into tranches that receive principal in sequence, distributing prepayment and interest-rate risk differently across tranches. A straight pass-through certificate shares every payment pro rata with no tranches. A CMO is not a municipal housing bond and is not backed by auto loans or credit card receivables, which are asset-backed securities.

Under the Investment Company Act of 1940, the three classifications of investment companies are:

• a.Open-end companies, closed-end companies, and unit investment trusts
• b.Diversified companies, non-diversified companies, and face-amount certificate companies
• c.Management companies, unit investment trusts, and real estate investment trusts (REITs)
• d.Face-amount certificate companies, unit investment trusts, and management companies✓

Section 4 of the Act divides investment companies into three principal classes: face-amount certificate companies, unit investment trusts, and management companies. Open-end and closed-end companies are the two subclasses of management companies, and diversified and non-diversified are a separate subclassification of management companies. REITs are not a class under the Act.15 USC 80a-4

For a management company to call itself diversified under the Investment Company Act of 1940 (the 75-5-10 test), with respect to 75% of its assets it must ensure that:

• a.No more than 5% is in any one issuer and it owns no more than 10% of any issuer's voting securities✓
• b.No more than 10% is in any one issuer and it owns no more than 5% of that issuer's outstanding voting stock
• c.No more than 5% is in any one issuer and no more than 25% is in any one industry
• d.All 100% of its assets meet the 5% and 10% limits, with no unrestricted portion

The 75-5-10 test requires that, for 75% of total assets, no more than 5% be invested in any single issuer and no more than 10% of any one issuer's voting securities be held. The two percentages are not reversed, the limits apply to 75% of assets and not all of them, and the remaining 25% is unrestricted. The 25% industry limit is a separate concentration policy, not part of the diversification test.15 USC 80a-5(b)(1)

A mutual fund has total assets of $100 million, total liabilities of $2 million, and 4.9 million shares outstanding. Its net asset value (NAV) per share is:

• a.$20.41
• b.$0.49
• c.$20.00✓
• d.$2.04

NAV per share equals net assets divided by shares outstanding: ($100 million minus $2 million) divided by 4.9 million equals $98 million divided by 4.9 million, or $20.00. Liabilities must be subtracted before dividing.

Under FINRA rules, the maximum sales charge on the purchase of an open-end mutual fund is:

• a.8.5% of the public offering price✓
• b.5% of net asset value
• c.There is no maximum
• d.12% of total fund assets

FINRA caps mutual fund sales charges at 8.5% of the public offering price, and the full 8.5% is allowed only if the fund offers breakpoints, rights of accumulation, and reinvestment of distributions at NAV. The charge is figured on the POP.

An open-end fund has a net asset value of $9.20 per share and a maximum sales charge of 8%. Its public offering price (POP) is:

• a.$8.46
• b.$10.00✓
• c.$9.94
• d.$9.20

POP equals NAV divided by (1 minus the sales charge percentage): $9.20 divided by 0.92 equals $10.00. The sales charge is figured on the POP, not the NAV, so simply adding 8% of NAV to reach $9.94 is the trap.

A 12b-1 fee charged by a mutual fund is:

• a.A contingent deferred sales charge that declines over time and is paid only when the investor redeems shares
• b.A one-time front-end sales charge deducted from the amount invested at purchase
• c.An annual fee deducted from fund assets to cover distribution and marketing costs✓
• d.A management fee paid to the investment adviser for selecting the portfolio's securities

A 12b-1 fee is an ongoing annual charge against fund assets for distribution, marketing, and sometimes shareholder servicing. A fund charging more than 0.25% generally may not call itself no-load. It is not a back-end sales charge (a contingent deferred sales charge), not a front-end load, and not the management fee that pays the adviser.

Class B mutual fund shares are typically characterized by:

• a.A level annual charge of about 1% through 12b-1 fees plus a one-year deferred sales charge, with no conversion
• b.A contingent deferred sales charge that declines the longer the shares are held, often converting to Class A over time✓
• c.A front-end load paid at purchase and reduced by breakpoints for larger investments
• d.Sales available only to institutions, with no sales charge and no 12b-1 fee

Class B shares carry a back-end contingent deferred sales charge that decreases over the holding period and usually convert to lower-cost Class A shares after several years. A front-end load reduced by breakpoints describes Class A shares, a level annual charge with a short deferred charge and no conversion describes Class C shares, and institutional shares have neither sales charges nor 12b-1 fees.

During the pay-in (accumulation) phase of a variable annuity, an investor's contributions purchase:

• a.Accumulation units, whose number varies as contributions are made while their value fluctuates with the separate account✓
• b.Units of the insurer's general account, which credit a guaranteed minimum interest rate
• c.Fixed-dollar credits whose value never falls below the premiums contributed
• d.Annuity units, which set the size of each monthly payment for the rest of the contract

Contributions buy accumulation units during the pay-in phase; at annuitization these convert to a fixed number of annuity units whose value then varies with separate-account performance to determine each payment. Annuity units belong to the payout phase. General-account credits with a guaranteed minimum describe a fixed annuity, and a variable annuity gives no guarantee that value stays above premiums paid.

In a variable annuity, if the separate account's actual return exceeds the assumed interest rate (AIR), the next monthly annuity payment will:

• a.Increase relative to the prior payment✓
• b.Decrease relative to the prior payment
• c.Remain fixed for the life of the contract
• d.Fall to zero

Payments rise when actual performance exceeds the AIR, stay level when it equals the AIR, and fall when it lags the AIR. The AIR is a benchmark used to set payments, not a guaranteed return.

An equity-indexed annuity (EIA) credits interest based on:

• a.The performance of the investor's chosen subaccounts, with no guaranteed minimum credited interest
• b.A fixed rate declared by the insurer that is guaranteed not to change for the life of the contract
• c.The performance of a stock index, subject to features such as a participation rate and a cap, with a guaranteed minimum✓
• d.The full price return of a stock index, with no participation rate or cap on gains and no minimum

An EIA is a fixed annuity that links credited interest to an index such as the S&P 500 but limits gains through participation rates and caps, while guaranteeing a minimum return. Subaccount performance with no guarantee describes a variable annuity, a rate that never changes describes a traditional fixed annuity, and an uncapped index return with no minimum is not how an EIA credits interest.

Compared with term life insurance, whole life insurance:

• a.Fluctuates in value with a separate investment account chosen by the policyholder
• b.Is always cheaper for the same death benefit
• c.Provides coverage only for a set number of years with no savings element
• d.Builds cash value and provides lifelong coverage as long as premiums are paid✓

Whole life offers permanent coverage plus a cash-value component at higher premiums than term. Term provides pure death-benefit protection for a stated period with no cash value, which is the trap. Variable life ties value to a separate account.

A call option with a strike price of $50 is held while the underlying stock trades at $55. The option's intrinsic value is:

• a.$55
• b.$0
• c.$50
• d.$5✓

A call's intrinsic value equals the stock price minus the strike when positive: $55 minus $50 equals $5, so the call is in the money. Any premium above $5 represents time value, not intrinsic value.

An investor buys a call with a $50 strike for a premium of $3. The breakeven price of the underlying at expiration is:

• a.$50
• b.$53✓
• c.$3
• d.$47

Breakeven for a long call equals the strike price plus the premium paid: $50 plus $3 equals $53. The stock must rise above breakeven for the buyer to profit, and the maximum loss is the $3 premium.

Rights of accumulation in a mutual fund allow an investor to:

• a.Count the current value of existing holdings toward reaching a breakpoint on new purchases✓
• b.Commit in writing to invest a stated amount within 13 months to earn a reduced sales charge
• c.Exchange shares of one fund for shares of another fund in the same family without paying a new sales charge
• d.Reinvest dividends and capital gains distributions in additional shares without paying a sales charge

Rights of accumulation let an investor qualify for a reduced sales charge by adding the value of prior holdings to new investments to reach a breakpoint. Unlike a letter of intent, they need not be pledged in advance. A written commitment to invest a stated amount over a period is a letter of intent, exchanging among funds in a family is a conversion (exchange) privilege, and sales-charge-free reinvestment of distributions is the reinvestment privilege.

Which characteristic applies to a U.S. Treasury bill?

• a.Its interest is exempt from federal income tax but subject to state and local income tax
• b.It is issued at par, matures in 30 years, and pays a fixed coupon every six months
• c.It is issued at a discount, matures in one year or less, and pays no periodic interest✓
• d.Its principal adjusts with the CPI and it pays a fixed rate of interest on the adjusted principal

T-bills mature in one year or less and are sold at a discount, returning par at maturity with no coupons. Like all Treasuries, their interest is federally taxable but exempt from state and local tax, so the reversed tax statement is the trap. A 30-year maturity with semiannual coupons describes a Treasury bond, and CPI-adjusted principal describes TIPS.

An equipment trust certificate is a debt security that is:

• a.Secured by a first mortgage on the real estate that the issuer owns
• b.Secured by specific physical equipment such as aircraft or railcars owned by the issuer✓
• c.Secured by securities of other companies that the issuer deposits with a trustee
• d.Backed only by the issuer's general credit, ranking behind all secured creditors in a liquidation

An equipment trust certificate is secured by title to specific equipment and is commonly issued by transportation companies, making it a secured bond. A mortgage bond pledges real property, a collateral trust bond pledges securities held by a trustee, and a debenture is backed only by general credit, which is the unsecured trap.

In a corporate liquidation, a subordinated debenture is paid:

• a.After other general creditors and senior debt, but before preferred and common stockholders✓
• b.Ahead of secured bondholders and senior debt, since subordinated status gives holders a first-priority claim
• c.After preferred stockholders but before common stockholders
• d.Pro rata with common stockholders once all senior and general creditors are paid

Subordinated debt ranks below senior debt and general creditors but still ahead of equity holders. The liquidation priority runs secured creditors, then senior debt, then general creditors, then subordinated debt, then preferred, then common stock. Subordination lowers a claim rather than raising it, and being a creditor, a subordinated debenture holder is paid before any preferred or common stockholder, not alongside them.

A closed-end fund whose shares trade at a market price above net asset value is said to trade at:

• a.A discount
• b.Its redemption value
• c.A premium✓
• d.Par value

Closed-end fund shares trade on an exchange at supply-and-demand prices that can exceed NAV (a premium) or fall below it (a discount). Only open-end fund shares always transact at NAV, so the redemption-value option is the trap.

For a callable bond trading at a premium, the yield figure that assumes the bond is redeemed at the first call date is the:

• a.Current yield
• b.Nominal yield
• c.Tax-equivalent yield
• d.Yield to call✓

Yield to call computes the return if the bond is redeemed at the call date and call price. For a premium callable bond, the yield to call is typically lower than the yield to maturity, and the more conservative of the two is quoted as the yield to worst.

A Series I savings bond issued by the U.S. Treasury earns a return based on:

• a.A fixed rate set at purchase, with the Treasury guaranteeing the bond will double in value in 20 years
• b.A variable rate tied to the prevailing yield on Treasury bills, reset every six months
• c.A combination of a fixed rate and an inflation rate that adjusts with the CPI✓
• d.The inflation rate alone, adjusted every six months, with no fixed rate component

Series I savings bonds pay a composite rate combining a fixed rate, constant for the life of the bond, and a semiannually adjusted inflation rate tied to the CPI, protecting purchasing power. A 20-year doubling guarantee describes Series EE bonds, and a rate that follows Treasury bill yields is not how I bonds work. The fixed component is part of the composite, so the inflation rate alone is incomplete. Interest is state-tax exempt and federally deferrable until redemption.

A key difference between an exchange-traded fund (ETF) and a traditional open-end mutual fund is that an ETF:

• a.Trades intraday on an exchange at market-determined prices and can be sold short or bought on margin✓
• b.Always trades at exactly its net asset value, since authorized participants keep the price aligned
• c.Must be actively managed, since index tracking is permitted only for open-end mutual funds
• d.Is sold by the fund directly to individual investors at the next-calculated net asset value

ETFs trade throughout the day at market prices and, like stocks, can be margined or sold short, whereas open-end mutual fund shares transact only at end-of-day NAV. Arbitrage by authorized participants keeps an ETF's price close to NAV but does not guarantee it, and ETFs can trade at a premium or discount. Many ETFs are designed specifically to track an index, and individual investors buy and sell them in the market rather than from the fund.

Unlike a fixed annuity, a variable annuity is:

• a.Guaranteed by the insurer's general account against any loss of principal
• b.Regulated only by state insurance departments, since it is sold by licensed insurance agents
• c.Regulated as a security requiring a prospectus, because the owner bears the investment risk of the separate account✓
• d.Guaranteed a minimum return, with the insurer bearing all of the investment risk

A variable annuity's value fluctuates with separate-account subaccounts, placing investment risk on the owner, so it is a security requiring registration and prospectus delivery, and selling it requires securities registration. A fixed annuity shifts risk to the insurer and is not a security. A variable annuity does not guarantee principal or a minimum return, and it is not regulated by insurance departments alone.

Four bonds mature in ten years and carry identical credit quality. Which one has the longest duration?

• a.The 8% coupon bond, because its large coupons are reinvested each period
• b.The zero-coupon bond, because the holder receives no cash until maturity✓
• c.The floating-rate note, because its coupon resets with short-term rates
• d.The 5% coupon bond callable in two years at a premium above par value

Duration is the weighted average time until a bond's cash flows are received. A zero-coupon bond has only one cash flow, at maturity, so its duration equals its maturity of ten years, the maximum available in this group. Coupon bonds return cash sooner, which pulls duration below maturity, and the higher the coupon the shorter the duration. A floating-rate note reprices at each reset, so its interest-rate duration is very short.

A bond portfolio has a modified duration of 7. If market yields rise by one percentage point, the portfolio's value is expected to:

• a.Decline by approximately 7%✓
• b.Decline by approximately 0.7%
• c.Increase by approximately 7%
• d.Increase by approximately 1%

The duration approximation is: percentage price change is roughly the negative of modified duration multiplied by the change in yield. Here that is -7 x 1.00% = -7%. On a $1,000,000 portfolio the estimated loss is about $70,000. Prices and yields move inversely, so a rate increase must produce a price decline, and duration tells you how large it should be.

Convexity in a bond portfolio describes the fact that:

• a.The price-yield relationship is curved rather than a straight line✓
• b.Credit spreads always widen when the general level of rates rises
• c.Coupon income is reinvested at a constantly increasing interest rate
• d.Duration and maturity are identical for every fixed-coupon security

Duration is a straight-line estimate, but the actual price-yield curve bends. With positive convexity, a bond gains more when yields fall than it loses when yields rise by the same amount, so duration alone understates gains and overstates losses. That curvature matters most for large rate moves and for long-duration bonds.

Under widely used rating scales, the lowest rating that is still considered investment grade is:

• a.BB+ from Standard & Poor's, or Ba1 from Moody's
• b.A- from Standard & Poor's, or A3 from Moody's
• c.B from Standard & Poor's, or B2 from Moody's
• d.BBB- from Standard & Poor's, or Baa3 from Moody's✓

Investment grade runs from AAA/Aaa down through BBB-/Baa3. The first rung below that line, BB+/Ba1, begins the speculative or high-yield tier. The distinction is not cosmetic: many fiduciary and institutional mandates prohibit holding below-investment-grade paper, so a downgrade across the line can force selling.

A sinking fund provision in a bond indenture requires the issuer to:

• a.Repurchase its own common shares whenever the bonds trade below par
• b.Set aside money each year to retire portions of the issue before maturity✓
• c.Pledge specific plant and equipment as collateral for the outstanding debt
• d.Increase the stated coupon rate whenever its credit rating is downgraded

A sinking fund forces the issuer to accumulate cash and redeem a portion of the bonds on a schedule. That reduces default risk near maturity, which is why sinking fund bonds usually yield slightly less than comparable bonds without one. The trade-off for the investor is that a specific bond may be called away early through the sinking fund draw.

A put feature attached to a corporate bond benefits the investor most when:

• a.Interest rates fall, because the issuer must then increase the stated coupon
• b.Inflation declines, because the principal amount is adjusted upward yearly
• c.Interest rates rise, because the bond can be sold back to the issuer at par✓
• d.The issuer's rating improves, because the bond will be called at a premium

A put bond lets the holder force redemption at par on set dates. When rates rise, an ordinary bond falls in price, but the put holder can hand the bond back at par and reinvest at the new higher rates, so the put limits the downside. A call feature is the mirror image and benefits the issuer when rates fall.

A Treasury note is quoted at 99-16. For a bond with $1,000 par value, the dollar price is:

• a.$991.60
• b.$1,001.60
• c.$995.00✓
• d.$999.16

Government notes and bonds are quoted in points and 32nds of a point. The '16' means 16/32, which is 0.50 of a point, so the quote is 99.50% of par: 0.9950 x $1,000 = $995.00. Reading the digits after the hyphen as cents or as hundredths is the classic trap in this question type.

A long-term U.S. Treasury bond held to maturity by an investor is generally:

• a.Free of purchasing power risk but exposed to reinvestment risk
• b.Free of both default risk and interest rate risk at all maturities
• c.Free of interest rate risk but fully exposed to default risk
• d.Free of default risk but fully exposed to interest rate risk✓

Treasuries carry the full faith and credit of the U.S. government, so credit or default risk is treated as negligible. They are not risk-free in a broader sense: a long-maturity Treasury has substantial duration, so its market price falls when yields rise, and its fixed coupons lose real value if inflation accelerates. Treasury interest is taxable federally but exempt from state and local income tax.

Which date determines the shareholders who are entitled to receive a declared cash dividend?

• a.The settlement date of the investor's most recent purchase
• b.The payable date, on which the distribution is actually made
• c.The declaration date, on which the board announces the dividend
• d.The record date, on which the issuer identifies its shareholders✓

The board declares a dividend on the declaration date, fixes a record date, and pays on the payable date. Only holders on the issuer's books as of the record date receive the payment. The ex-dividend date is the market convention that identifies when a buyer no longer purchases the right to that dividend, and the stock's price typically adjusts downward by roughly the dividend amount on that day.

Cumulative voting for directors differs from statutory voting because cumulative voting allows a shareholder to:

• a.Cast one vote per share for every candidate standing for election that year
• b.Carry unused votes forward and apply them at the next annual meeting
• c.Buy newly issued shares first to keep the same percentage of ownership
• d.Concentrate all available votes on one or a few candidates for the board✓

Under statutory voting a holder may cast up to one vote per share for each open seat, and votes cannot be shifted between candidates. Cumulative voting pools the same total votes (shares times open seats) and lets the holder pile them on a single nominee, which is why it favors minority shareholders, who can occasionally elect one director. Votes cannot be carried to a later meeting, and buying new shares first to maintain ownership percentage is the preemptive right, a different shareholder protection.

An exchange-traded note differs from an exchange-traded fund principally because the note:

• a.Must distribute at least 90% of its net investment income every calendar year
• b.Holds a portfolio of the underlying securities in a segregated custody account
• c.May be redeemed each day at net asset value directly with the sponsoring fund
• d.Is an unsecured debt obligation that exposes the holder to issuer credit risk✓

An ETN is a senior unsecured note that promises the return of an index; it owns no basket of securities. If the issuing bank fails, the investor is a general creditor, so tracking is precise but credit risk is real. An ETF holds actual portfolio assets at a custodian, which is the structural protection an ETN lacks.

A daily leveraged or inverse ETF is generally unsuitable as a long-term holding because:

• a.It resets exposure daily, so compounding causes results to diverge over time✓
• b.It has a stated maturity date, so principal is lost if shares are held past expiration
• c.It resets its leverage only once a year, so it cannot track the index during the year
• d.It may be sold only to accredited investors who satisfy net worth standards

These funds are engineered to deliver a multiple of an index's return for one day. Because the leverage is rebalanced daily, the path of returns matters: in a volatile but flat market a 2x fund can lose money even though the index ends where it started. Over months, results can differ sharply from twice the index's cumulative move, which is why they function as short-term trading tools. They have no maturity date, they reset daily rather than yearly, and they are not restricted to accredited investors, although firms must apply heightened suitability scrutiny when selling them.

A closed-end investment company differs structurally from an open-end fund because a closed-end fund:

• a.Issues a fixed number of shares that afterward trade between investors✓
• b.May not use leverage or issue any senior securities under any condition
• c.Issues new shares continuously and redeems them at net asset value
• d.Must invest at least 75% of its assets in U.S. government securities

A closed-end fund raises capital once in a public offering, after which the share count is essentially fixed and shares change hands on an exchange at whatever price supply and demand set, often a discount or premium to net asset value. An open-end fund continuously issues and redeems at net asset value. Closed-end funds may also use leverage, which open-end funds are largely restricted from doing.

Class C mutual fund shares are generally characterized by:

• a.A deferred load declining over six years and later conversion to Class A
• b.No front-end load, a higher ongoing 12b-1 fee, and a short contingent charge✓
• c.A front-end sales load, lower annual expenses, and breakpoint discounts
• d.No sales charge of any kind, with all fund costs paid by the sponsor

Class C is the level-load share: the investor pays nothing up front, a contingent deferred sales charge usually applies only for about the first year, and the annual 12b-1 fee is comparatively high. That makes Class C relatively cheap for a short holding period and expensive for a long one. Class A charges the front-end load with breakpoints, and Class B is the long-declining deferred load that converts to Class A.

Under the forward pricing rule, an order to purchase open-end mutual fund shares received at 2:00 p.m. is executed at:

• a.The net asset value that is next computed after the order is received✓
• b.The average net asset value over the five preceding business days
• c.The market price at which the fund's shares last changed hands
• d.The net asset value computed at the close of the prior business day

Open-end funds do not trade intraday. Rule 22c-1 under the Investment Company Act of 1940 requires that purchase and redemption orders be priced at the next net asset value calculated, normally at the close of that trading day. Forward pricing exists to stop investors from buying at a stale price they already know is favorable.

Compared with a listed equity REIT, a non-traded REIT typically exposes an investor to:

• a.Lower total fees, because no selling compensation is ever paid to brokers
• b.Less credit risk, because federal deposit insurance covers the shareholders
• c.Greater liquidity risk, because the shares are not listed on an exchange✓
• d.Greater interest rate risk, because it may hold only variable-rate debt

A non-traded REIT has no secondary market, so an investor generally must wait for a limited share repurchase program or a liquidity event that may be years away. Front-end selling and organizational costs are typically higher, not lower, and no federal insurance applies. Liquidity and valuation opacity are the central suitability concerns an adviser must address.

A mortgage REIT generates most of its income from:

• a.Management fees charged to outside investors in its affiliated funds
• b.Capital gains realized on the sale of commercial buildings it develops
• c.Rental payments collected from the tenants of properties that it owns
• d.The spread between interest earned on mortgage assets and its borrowing cost✓

An equity REIT owns buildings and collects rent. A mortgage REIT owns mortgage loans and mortgage-backed securities, borrows short, lends long, and earns the net interest spread. That leaves it far more sensitive to changes in interest rates and to prepayment behavior than a typical equity REIT.

Universal life insurance differs from traditional whole life insurance primarily because universal life:

• a.Provides pure protection for a stated term with no cash value component
• b.Invests all cash value in separate account subaccounts chosen by the owner
• c.Allows the owner to vary premium payments and to adjust the death benefit✓
• d.Requires a level premium for life and guarantees a fixed cash value schedule

Universal life unbundles the policy: within limits the owner may pay more, pay less, or skip a premium, and may raise or lower the death benefit subject to underwriting. Whole life uses a fixed level premium and guaranteed cash values. Investing the cash value in separate account subaccounts describes variable life, and term insurance builds no cash value at all.

For a given annuitant and account value, which annuity settlement option produces the largest monthly payment?

• a.Life only, because payments cease at the annuitant's death✓
• b.Installment refund, because any unused principal is repaid to the heirs
• c.Life with 20-year period certain, because payments are guaranteed
• d.Joint and last survivor, because payments cover two lives

The insurer sizes each payment against how long it expects to pay. Life only (straight life) carries no guarantee to anyone after the annuitant dies, so the expected payout period is shortest and each check is largest. Every added guarantee, whether a refund feature, a certain period or a second life, lengthens or secures the expected obligation and lowers the payment. Life only also carries the greatest risk of forfeiture for the annuitant's heirs.

An investor age 50 takes a partial withdrawal from a nonqualified deferred annuity that has grown above its cost basis. The withdrawal is generally:

• a.Taxed as ordinary income on the earnings first, plus a 10% penalty✓
• b.Treated entirely as a tax-free return of the owner's after-tax basis
• c.Excluded from gross income because annuity contracts are tax-exempt
• d.Taxed as a long-term capital gain on the full amount withdrawn

Nonqualified annuity withdrawals follow last-in, first-out ordering: earnings are deemed distributed before the after-tax principal. Those earnings are ordinary income, never capital gain, and because the owner is under age 59 1/2 an additional 10% penalty applies to the taxable portion. Basis comes out tax-free only after the earnings have been exhausted.

The exclusion ratio applied to payments from an annuitized nonqualified annuity determines:

• a.The share of the separate account invested in fixed-income subaccounts
• b.The maximum commission an agent may receive on the initial purchase
• c.The portion of each payment treated as a tax-free return of cost basis✓
• d.The percentage of the contract that may be surrendered without a charge

When a nonqualified annuity is annuitized, each payment is part return of the owner's after-tax investment and part taxable earnings. The exclusion ratio is the investment in the contract divided by the expected total return, and it fixes the tax-free fraction of every payment. Once total basis has been recovered, later payments become fully taxable as ordinary income.

Section 1035 of the Internal Revenue Code permits a contract owner to:

• a.Exchange one annuity contract for another without current tax on the gain✓
• b.Convert a nonqualified annuity into a Roth IRA entirely free of income tax
• c.Withdraw annuity earnings before age 59 1/2 without any penalty tax at all
• d.Deduct nonqualified annuity premiums from current-year gross income

A 1035 exchange lets an owner move from one life insurance or annuity contract to another of a permitted type without triggering tax on accumulated gain; the old basis carries over. It does not create a deduction, waive the early distribution penalty, or turn nonqualified money into Roth money. Advisers must still weigh new surrender charges and a fresh surrender period before recommending an exchange.

An investor who writes a call option without owning the underlying stock faces:

• a.No meaningful market risk, because the premium is collected up front
• b.An unlimited maximum loss, because the stock price has no upper bound✓
• c.A maximum loss equal to the strike price multiplied by 100 shares
• d.A maximum loss limited to the premium received when the option was sold

The uncovered (naked) call writer must deliver stock at the strike price no matter how high the market goes, and there is no theoretical ceiling on a share price, so the loss is theoretically unlimited. Writing a call against shares already owned (a covered call) caps the risk, because the shares are available for delivery. The premium received is the writer's maximum gain, not a limit on the loss.

An investor buys a put with a $40 strike price for a $2 premium. The breakeven price of the underlying at expiration is:

• a.$36
• b.$40
• c.$38✓
• d.$42

For a long put, breakeven equals strike minus premium: $40 - $2 = $38. At $38 the put's intrinsic value of $2 exactly offsets the $2 paid, so the position nets zero. Below $38 the buyer profits; above $40 the put expires worthless and the $2 premium is the maximum loss. Strike plus premium ($42) is the breakeven for a long CALL, which is the intended trap.